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The College Savings Cheat Sheet: It’s As Easy As 5-2-9

For parents seeking to pay for their kids’ college educations, here are three numbers that will make the task much easier: 5, 2, 9.

We’re talking about 529 college saving plans, which are named for the IRS tax code that created them. With a 529, you can save for college tax-free, as long as the money is used for higher-education expenses. Despite this huge tax advantage, 529 plans are still overlooked — only one in four parents saving for college are putting money in a 529, according to a recent survey by lender Sallie Mae.

Why are families missing out on 529s? Well, chalk it up to confusion. Nearly every state has its own plan, and some operate more than one, so shopping around can be daunting. (You can invest in nearly any state’s 529, not just your own.) And much like a 401(k), each 529 presents you with a wide array of investment choices to sort through. Still, you can quickly drill down to the right choice for you — just follow these five steps:

1. Check out your state’s tax breaks. First determine what tax benefits your state offers — most states let you claim a deduction for contributions to a 529. (Go to savingforcollege.com, where you can look up each state’s tax breaks and 529 plans.) If you live in a state with no income tax, or one that doesn’t offer a tax deduction, you’re free to look elsewhere. You can also shop around if you live in one of the six states (including Missouri and Pennsylvania) that allow you to deduct contributions to any state’s 529 plan.

2. Assess your state’s plans. If your state does give you tax breaks, you’re typically better off investing at home, especially if the deductions are generous. But there are exceptions. When the local 529 offers poorly performing funds or charges high costs — say, more than 0.5% — you may do better by going elsewhere. (More on costs below.) And for those investing for young kids, you may be able to start out with your in-state plan and later roll over your money to a better plan elsewhere. Some 14 states allow you to move your funds to an out-of-state 529 without penalty as long as you stay invested for a few years.

3. Keep your costs down. For many years 529s levied higher fees than retail brokerages did for comparable offerings, which took a big bite out of returns. But competition is finally pushing down costs.

To find a low-cost 529, stick with those that are direct-sold — meaning you invest directly with the plan — and avoid plans sold through brokers and advisers, who typically layer on fees. If you sort through the choices, you’ll typically find funds charging less than 0.5% — often index offerings that cost 0.2% or less. (You can find links to the different state plans at collegesavings.org).

4. Opt for an age-based fund. The simplest and best choice for many families is an age-based portfolio, which is similar to a retirement target-date fund: You get instant diversification and the asset mix shifts to become more conservative as your child nears college. (That automatic feature is especially helpful for 529s, since you can generally make only one investment change a year.) But make sure you’re comfortable with the asset mix, since some age-based portfolios are more risky than others — an aggressive fund for a 10-year-old might have 70% in stocks, while a conservative choice might hold less than 30%.

5. Protect your portfolio. When you’re one or two years away from paying that first tuition bill, you may want to shift out of the age-based fund to even safer assets. Just make sure they really are safe.

Many families were hit hard in 2008 by losses in their 529 bond funds, which turned out to hold subprime mortgage securities. Today fixed-income investors face the prospect of rising interest rates, which would push down bond prices. The longer the maturity of the bond funds, the bigger the potential losses.

Still, 529s offer many low-risk options, such as a high-quality short-term bond fund, which is likely to hold up relatively well if rates rise. (You can look up the fund’s average maturity and credit quality at Morningstar.com.) Many 529s also offer stable value funds, which are backed by an insurance company and hold a steady net asset value — they pay a yield equivalent to a short-term bond fund. And some plans, like Ohio’s CollegeAdvantage 529, let you invest in bank CDs. You can’t get safer than that.